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KeitH McCulLoUghWITH RiCH BLAKE

McCullOUghBLake

KEITH MCCULLOUGH is the founder of Research Edge, a provider of independent securities markets research that has become the go-to source for analysis and trade recommendations among savvy money managers. He is also a Bloomberg TV Contributing Editor. McCullough started in the business in 1999 as an equity analyst at Credit Suisse First Boston. From there, he ran assets for Dawson-Herman Capital Management’s Millennium Fund, and then launched his own fund, Falcon Henge Partners LLC, which was integrated in to Magnetar Capital. He then moved on to become a portfolio manager at Carlyle–Blue Wave until 2007. McCullough is a graduate of Yale University and also former captain of the Yale hockey team.

RICH BLAKE was the cofounder and executive editor of Trader Monthly magazine. He frequently contributes to CNBC’s Power Lunch and to Alphaand Portfolio magazines. Prior to the launch of Trader Monthly, Blake wrote for Institutional Inves-tor. He is the author of two books, The Day Donny Herbert Woke Up and Talking Proud: Rediscovering the Magical Season of the 1980 Buffalo Bills.

J A C K E T D E S I G N : M I C H A E L J . F R E E L A N D

$29.95 USA / $35.95 CAN

Diary of a Hedge Fund Manager is an insider’s view of the high-stakes money management world. In a distinctly straightforward and, at times, humorous style, Keith McCullough

and Rich Blake take you on the journey of a young and successful hedge fund manager and former junior hockey player from Thunder Bay, Ontario, as he gets recruited to the Ivy League, stumbles onto the nexus of the hedge fund universe, and then gets a crack at running his own pile—becoming one of the best young portfolio managers on the Street.

But when the young portfolio manager fi nds himself working for one of the world’s most prestigious fi rms—helping to run their hedge fund operation just as the market is starting to crack in 2007—McCullough becomes a lonely voice of reason in a world that rewards groupthink and disregards the adage about past performance having no bearing on future results. When McCullough fi nds himself shown the door, the story takes a fascinating turn into the world of independent research and no-holds-barred criticism.

Page by page, this fast-paced ride through the world of hedge funds reveals the unvarnished truth of how Wall Street and hedge funds really operate and offers real-world investment lessons you can take away and put to good use.

Written with the authority of someone who knows how Wall Street and hedge funds work, yet accessible to even a casual follower of fi nance, Diary of a Hedge Fund Manager mixes a constructive critique of the investment industry with fundamental lessons that any investor will fi nd valuable.

O V E R A L L M A T T E F I N I S H

“An engaging and fascinating memoir of a Wall Street insider who foresaw the crisis and lost his job for it. McCullough has written an insightful fi rsthand account of our modern Rome before—and after—its fall. The author stands head and shoulders above his peers with his phenomenal trading track record, personal integrity, and skill at communicating his unique experiences.”

— Richard L. Peterson, MD, Managing Director, MarketPsy Capital LLC; author, Inside the Investor's Brain

“If an unholy offspring of Lester Bangs and Don Cherry traded and wrote a fi nancial market diary, it might be something like the smart, hip, and crunching commentary hedge fund manager Keith McCullough delivers every day. Keith is on a short list of must-reads in a business fi lled with also-rans.”

— Dr. Paul Kedrosky, Editor, Infectious Greed; Managing Director, IG Holdings; Senior Fellow, Kauffman Foundation

“Diary of a Hedge Fund Manager should be added to the list of must-read books on Wall Street. It is very rare that readers get this kind of insight into the world of what Wall Street calls the “smart money”. McCullough’s exciting and inspirational story reinforces the fact that hard work pays off. The book does a great job of pointing out that, on Wall Street, common sense and hard work trump a PhD—without actually saying it. His honesty is refreshing and reminds us all that the giants of the hedge fund world are mere mortals. This story is one that both Wall Street and Main Street can relate to and learn from.”

— Douglas M. Famigletti, CFA, Managing Director, Griffi n Asset Management, Inc.

“Like Liar’s Poker and Fiasco before it, Diary of a Hedge Fund Manager offers a fascinating, funny, and frightening account of life on the Street. An indispensable account of how the fi nancial-industrial complex destroyed so much of the ‘value’ it purported to create.”

—Dan Burrows, Senior Writer, DailyFinance

“The hedge fund world is notoriously secretive. But in Diary of a Hedge Fund Manager, Keith McCullough reveals what's behind the curtain to show an industry that frequently is little more than a lot of smoke and mirrors, much the same way that Toto revealed the Great and Mighty Wizard of Oz to be nothing more than an ordinary man.”

—Michelle Leder, founder and Editor, footnoted.org; author, Financial Fine Print

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Diary of a Hedge Fund Manager

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Diary of a Hedge Fund Manager

From the Top, to the Bottom, and Back Again

KEITH MCCULLOUGH WITH

RICH BLAKE

John Wiley & Sons, Inc.

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Copyright © 2010 by Keith McCullough and Rich Blake. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4470, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifi cally disclaim any implied warranties of merchantability or fi tness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profi t or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002.

Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com.

Library of Congress Cataloging-in-Publication Data:

McCullough, Keith, 1975–

Diary of a hedge fund manager : from the top, to the bottom, and back again / Keith McCullough with Rich Blake. p. cm. Includes index. ISBN 978-0-470-52972-0 (cloth) 1. Hedge funds. 2. Investment advisors. I. Blake, Rich, 1968– II. Title. HG4530.M39 2010 332.64�524–dc22

2009035907

Printed in the United States of America

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For Jack

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Contents

Introduction 1

Chapter 1: Catch a Wave 9Chapter 2: Shipping Out 17Chapter 3: Welcome to the Jungle 29Chapter 4: Snapshots from the Dot.Com Bubble 39Chapter 5: Discovery 61Chapter 6: Flying with the Giants 79Chapter 7: Shifting for Myself 97Chapter 8: Sucked In 115Chapter 9: Worlds Collide 123Chapter 10: Exile on Wall Street 139Chapter 11: Lifting the Curtain 157Chapter 12: The Great Squeeze 185

Epilogue 197Acknowledgments 205About the Authors 207Index 209

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1

Introduction

My fi nal day in the hedge fund business was Friday, November 2, 2007. I ’ d enjoyed nearly a nine - year run on Wall Street, fi rst as a junior analyst at Credit Suisse First Boston before landing on

the buyside, working for hedge fund pioneer Jon Dawson, and then eventually co - founding a hedge fund with my partner, Harry Schwefel. Our fund was later absorbed into multi - billion - dollar Magnetar Cap-ital. My last - ever hedge fund job was running money as a Portfolio Manager and Managing Director at Carlyle - Blue Wave Partners.

At the time I worked at Carlyle - Blue Wave (February through November of 2007), the Carlyle Group — already well known around the world for its private equity prominence — was pushing into the hedge fund business. Its new hedge fund arm, Blue Wave, a joint venture with two ex - Deutsche Bank executives, made me Partner and gave me a seat on the fund ’ s Investment Committee, represent-ing the Long/Short Equity side of the business.

On the morning of what would turn out to be my last day in the business, I ducked out of our Midtown offi ce right before noon

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and walked down Fifth Avenue to buy a new pair of black loafers. The soles of the ones I had on weren ’ t exactly worn out and might have even lasted me another six months, but with my son Jack due to be born in the coming week, I felt it was time to start the next chapter of my life.

So did my bosses at Carlyle - Blue Wave. Later that afternoon I was told I was being let go. My days

trading a “ book ” for a hedge fund were over. I packed up my personal belongings, books, fi les, and notebooks into a couple of cardboard boxes, but I left my old shoes in the offi ce. When those dusty loafers were mailed to me a month later, I had already forgotten about them.

But I smiled.

■ ■ ■

During my brief time at Carlyle - Blue Wave, the fi rst cracks in private equity and in hedge funds — and in the fi nancial markets in general — were starting to manifest. The widening subprime mortgage crisis was starting to dominate the fi nancial press. It was clear, to me anyway, that a top had been reached and probably surpassed. My fi nal month of trading on Wall Street was a profi table one. My shorts were fi nally beginning to work out. But there was just no denying that I had turned in an unprofi table third quarter of 2007. Although the market took a nosedive in the early part of that August, it whipsawed right back up again later in the month and into September. In the end I ’ d been too bearish, too soon. Now I was being shown the door.

I had enjoyed the ride, made my eight fi gures, notched positive returns in 21 of 24 quarters. Still, unless you run the place, the hedge fund business is about being right each and every quarter. Being right early is called being wrong. But it seemed my last “ call, ” on the global market and on the asset management industry, was turning out to be right after all.

i n t r o d u c t i o n


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As my hedge - fund trading days came to a close in the autumn of 2007, the seeds of a new type of real - time research fi rm — something akin to a virtual hedge fund — took root in a fi nancial blog I had begun writing. My audience at fi rst included a few friends and former colleagues from the Street, but I mostly wrote for myself. For years, I ’ d diarized all of my investment decisions, logging observations and data points meticulously into 10 × 7 7/8 inch collegiate style composition notebooks, marble covered, 100 sheets per notebook. With spare time no longer a scarcity, I started writing every day, often recalling my experiences as an analyst and as a fund manager.

And I kept making calls on markets, and wrote about them, to keep an on - the - record hand in the game. One day, when my son was old enough, I could show him that in the last game Dad ever played as a hedge fund manager he got kicked off the team when an MVP trophy would have been more appropriate.

Having closed on October 9, 2007, at a record high of 1565.15, * the S & P 500 reached 1576.09, intra - day, on October 11, before entering the initial stage of what would be a monumental decline. Convinced the worst was yet to come, I began sharing my market views with anyone who cared to read them. I published a blog, MCM Macro, my token attempt to bring some semblance of transparency to the investing world, starting with publishing every call I was making and articulating the reasons why. Every call is still up there on that site. I made short - term, and longer - term forecasts, always owning up to miscues, always an open book insofar as my rationale was concerned. Never that strong a writer, I was fi nding I enjoyed it, looked forward to it, and tried to improve. I wrote constantly. I wrote from a position of truth. I had no agenda other than to chronicle my process and thoughts. No such “ open book ” existed in the hedge fund world, or for that matter at the large

*According to FactSet Research Systems Inc.; all of the market and securities data contained in this book, in fact, came from FactSet.

Introduction



4

banks and investment brokerage houses that sell research. In a market growing more perilous by the day, I was now giving former colleagues, family members, and friends full access to my portfolio management process. They saw every call in real time. In an industry that needed to creatively destruct before it could truly change, I felt like I would do my small part by being accountable in the meantime, even if I was merely a virtual Portfolio Manager.

On Tuesday, April 1, 2008, I posted a three - month perform-ance report for my MCM Macro model portfolio: +2.2 per-cent, compared to – 10 percent for the S & P 500 and – 14 percent for the Nasdaq. Along with a few partners, I offi cially opened the doors of Research Edge, my new fi rm, that month in New Haven, Connecticut, in a restored mansion once owned by hefty ex - U.S. President William Howard Taft, just a short walk from the Yale University campus.

As it turns out, my idea for a fresh approach to investment research had some heft of its own. I ’ ve since hired some 30 full - time employees, many of them former hedge fund analysts, including a few ex - Blue Wavers, at a time when the Street was laying off thou-sands. The roster of buyside fi rms that have regularly come to rely on our research has swelled from just a few to more than 100.

■ ■ ■

Why this book? Why now? Since leaving Wall Street to do real - time macro research, the

facts have largely played out on my side of the macro calls, calls that sorely needed to be made. I don ’ t think there was any remarkable genius to my viewpoints; oncoming fi nancial catastrophe was readily apparent to anyone who was allowed to be objective.

Unfortunately, the hedge fund business pays a higher multiple for short - term performance than it does long - term adherence to principles.


Introduction

5

We ’ re only now seeing the ugly side of that reality. Wall Street ’ s latest cycle of earnings gamesmanship and off - the - charts leveraging constituted an ambitious compensation mousetrap, not a sustainable business model.

When former Trader Monthly (now defunct) executive editor Rich Blake and I embarked on the early brainstorming for what would become this book, around December 2008, the timing and collaboration felt right. Wall Street was on its knees. Bernie Madoff was exposed. Rich and I both agreed our overriding goal would be to provide a stark, insider ’ s view of the hedge fund world, famously secretive and not well understood. Criticism would be meted out with context.

While the hedge fund industry has just gone through a signifi cant shakeout, we expect even more contraction going forward. Assets in hedge funds, once estimated to be as high as $ 2.9 trillion in the second quarter of 2008, dipped to $ 1.8 trillion as of the second quarter of 2009, according to HedgeFund.net . On average, hedge funds lost 18.3 percent in 2008, according to Hedge Fund Research. Many funds faced an onslaught of redemptions and requests for redemptions and, factoring in both outfl ows and investment losses, saw their assets cut in half during the fi nancial crisis. Looking at the deep end of the pool, some 268 U.S. - based hedge fund management companies had at least $ 1 billion in assets as of July 1, 2008, controlling a collective $ 1.68 trillion, according to Hedge Fund Intelligence. The number of U.S. - based management companies with at least $ 1 billion in hedge fund assets had, by the second quarter of 2009, dipped to 218 companies controlling a collective $ 1.13 trillion, according to HFI. HedgeFund.net ’ s database of individual funds with at least $ 100 million under management numbered 1,748 in June 2008; in June 2009, HFN said there were only 1,129 funds that big. At one point prior to the market meltdown, the total number of hedge funds was believed to have exceeded 10,000, according to HFN. Likely there were even more



6

individual funds, or limited partnerships (LPs), than the estimates could capture when one considers enigmatic offshore vehicles. Hedge Fund Research says 1,471 hedge funds liquidated in 2008, with 778 of those happening in the fourth quarter alone. That ’ s a 15 percent lop off. Another 668 funds liquidated in the fi rst half of 2009, according to HFR. While performance seems to be turning around at some funds, and new vehicles are always starting up, I still would not be surprised if another 10 to 15 percent of all hedge funds shuttered over the next year or so. I would not be surprised if such a pace of hedge fund shuttering continues in 2010.

For those who are still specifi cally working at hedge funds, and in the fi nancial industry in general, who survives and who thrives will depend on who among the pack most enthusiastically embraces principles and sound practices, old - fashioned concepts such as putting customers fi rst, no matter what. Now is the time to look in the mirror and rebuild the trust that has been destroyed. Work ethic and handshakes are important to me. I think they are to other people, too. Accountability and trust are transcending “ trends. ” I believe these trends are just now taking hold and that the U.S. fi nancial system is headed in a new direction.

Just as politics were transformed by YouTube and Twitter, so too will the fi nancial markets as they inevitably succumb to unprece-dented transparency. From Madoff to AIG, fi nancial cataclysm has drastically changed the way the industry is perceived. The barn door has been blown off its hinges, and the public at large continues to stare inside with disbelief.

Some 92 million Americans have money invested in mutual funds, according to the Investment Company Institute. Around 62 million Americans participate in some form of retirement plan, according to the Employee Benefi t Research Institute. An estimated 47 percent of American households, or 54.5 million households, have some form of ownership of stock or bonds, according to a joint study done by the ICI and the Securities Industry and Financial


Introduction

7

Markets Association. Has anyone from Wall Street told them any-thing about the fi nancial meltdown that they can understand? Or believe?

No matter what you glean from reading about my experiences, I trust you can see that the highs, lows, and lessons of a hedge fund manager are of no greater signifi cance than those of any other pro-fession. We all share the same intrinsic motivations, in work, and, for that matter, in life: to create; collaborate; meet challenges; take worthwhile risks, and avoid unnecessary ones. Money may or may not be the root of all evil, but we all crave validation. We all get up every morning hoping that everyone else is doing the right thing when nobody is looking. What follows is a glimpse, mine, of what hedge funds were doing during this past decade.

Keith R. McCullough CEO, Research Edge

New Haven, Connecticut Third Quarter 2009


9

Chapter 1

Catch A Wave

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The recruiter ’ s message was garbled and vague: Large, well - known private equity player looking to launch multi - strategy hedge fund. It was late November 2006. I already worked for a large,

well - known hedge fund fi rm, Magnetar Capital. Magnetar was launched in April 2005 by a 39 - year - old numerical savant named Alec Litowitz, formerly the Head of Equities at Citadel Investment Group and considered to be a master of merger arbitrage. Litowitz had joined forces with ex - Glenwood Capital Partners president Ross Laser. Man Group Plc had acquired Glenwood in 2000, pro-ducing a nice windfall for Laser; Litowitz, meanwhile, had been producing handsome profi ts at Citadel. Together, the two set up headquarters in Evanston, Illinois, outside Chicago and not far from Northwestern University. Magnetar opened its doors for business with $ 1.7 billion in assets under management. At the time, it was one of the largest hedge fund startups ever. Less than two years later

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Magnetar ’ s assets neared $ 4 billion, it had expanded its reach to open offi ces in New York and London, and it was charging after numerous forms of portfolio strategies not limited to merger arb or equities.

Around the time Magnetar was forming, I launched, along with my partner Harry Schwefel, a hedge fund management com-pany called Falconhenge Partners, and a fl agship hedge fund of the same name. We put up some impressive numbers, which eventually came to the attention of Laser, who proposed folding our team into Magnetar. Laser wasn ’ t alone in his pursuit during the fi rst half of 2006. Dan Och of Och - Ziff Capital Management was also court-ing Harry and me. Deciding which offer to take put us in an envi-able position, although it was still a diffi cult choice. In May 2006, we chose Magnetar.

The recruiter called not long after I ’ d joined Magnetar ’ s New York offi ce, and I wasn ’ t looking to leave. So I ignored the message.

Most hedge fund portfolio managers (PMs), if they ’ re any good, can expect to hear from a headhunter now and again, perhaps every other month. In the latter half of 2006, with hedge fund mania spik-ing, it seemed like I was getting calls from PM - seeking recruiters every other week.

Later that same November afternoon, the recruiter called again, and I let her go to voice mail again. This time, she mentioned the name of the fi rm looking to get into the hedge fund business: The Carlyle Group.

After the close, I called her back.

■ ■ ■

In terms of sheer size and clout, few investment fi rms are on Carlyle ’ s level. Around the time it set out to conquer the hedge fund business, Carlyle ’ s total assets under management were nearing $ 60 billion, spread across 50 - plus funds, mainly in private equity vehicles, and via

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Catch a Wave

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those funds Carlyle controlled huge stakes in hundreds of companies all around the world. With alternative asset management rivals The Blackstone Group and Fortress Investment Group both preparing to go public, it was hardly a secret that Carlyle might be entertaining a similar course.

Based in Washington, DC, the fi rm was setting up its new hedge fund arm, Carlyle - Blue Wave Partners, in the heart of Midtown Manhattan, securing prime commercial real estate on the Avenue of the Americas just south of Central Park, the New Wall Street, post-9/11. I was told Carlyle was sparing no expense, setting a launch target of $ 1 billion. Considering the fi rm ’ s access to institutional channels, corporate and state pension funds, nonprofi t foundations, and university endowments, not to mention the world ’ s wealthiest individuals, such a goal did not seem like a stretch. To Carlyle, $ 1 billion was strategically nimble.

My curiosity suffi ciently aroused, and having apparently passed the recruiter ’ s smell test, I soon sat down with the two ex - Deutsche Bank executives who had been tapped by Carlyle CEO David Rubenstein to create Carlyle - Blue Wave. Rick Goldsmith and Ralph Reynolds had formed a joint venture along with Carlyle that August and promptly set about building one of the largest, most ambitious hedge fund startup teams yet created in an era marked by a series of sizable, noteworthy hedge fund startups.

Reynolds had been Deutsche Bank ’ s global head of proprietary trading and would serve as Carlyle - Blue Wave ’ s CIO; Goldsmith, who had been in charge of a highly profi table hedge fund division of Deutsche Bank, would be the Chief Executive. They teamed up on fundraising and recruiting fund managers. They made quite a pair — Reynolds reserved to the point of saying next to nothing but listening intently, Goldsmith doing all the talking, amiable and sharp. Following a second episode of the “ Rick and Ralph Show, ” I found myself on an impromptu tour of Blue Wave ’ s new digs, completely empty at the time except for some workers doing

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